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backd — Interest Earning Liquidation Protection

A first introduction to the backd protocol.

backd is a decentralized protocol on Ethereum, which solves the problem of being liquidated, faced by borrowers in DeFi. The backd protocol generates interest for LPs, while protecting borrowers of over-collateralized loans on borrow and lending protocols (e.g. Compound, AAVE) against becoming liquidable.

On backd, liquidity providers (LPs) may deposit funds into asset-specific pools in exchange for pool-specific LP tokens. Pool deposits are employed in two ways.

First, by redeeming LP tokens for the underlying asset, funds in a pool may be used as back-up collateral, ready to increase collateral-to-debt ratios on borrow positions in borrowing and lending protocols. When collateral top ups occur, a fee is charged on the increment and subsequently distributed amongst the LPs for the pool of the collateral asset.

Second, a variable amount of the deposits in each pool is allocated via some investment strategy to generate additional yield via external protocols. The generated yield by a pool’ s strategy is ultimately diverted back into the pool and thereby distributed amongst the pool’s LPs.

The protocol incentivizes off-chain monitoring of borrow positions across DeFi protocols to report positions registered on backd that are eligible for collateral top ups. Any network participant may act as a backd keeper, call top ups in the backd protocol and be rewarded for it.

In the remainder of this post, we explain the use case for backd and outline the core components of it.

Over-collateralization is a fundamental building block of DeFi, protecting borrowing and lending protocols against credit risk. Ultimately borrowers are left with the responsibility of ensuring that their borrow positions remain over-collateralized. Should the collateral-to-debt ratio for a given borrow position drop below some liquidation threshold, the position becomes liquidable, whereby the locked collateral would get auctioned off at a discount to recover the debt. Given that any network participant can act as a liquidator, where in practice liquidations are triggered by very efficient liquidation bots, manually maintaining sufficiently high collateral-to-debt ratios is infeasible in times of high market volatility, exposing a borrower to high liquidation risk. An alternative to actively managing the collateral-to-debt ratio is to supply a sufficiently high amount of collateral. However, the more collateral is supplied, the higher the opportunity cost to the borrower of not being able to allocate these funds elsewhere and generate earnings from them. backd solves this problem by accepting deposits which are utilized to generate earnings until they are needed as a collateral top up on some other protocol.

Let’s assume that Alice has borrowed 1 ETH on Compound, which is collateralized with 525 DAI. Assuming that the initial price of 1 ETH is $350 and 1 DAI is pegged to $1, the collateralization ratio is equal to 150%. Due to the price volatility of ETH, Alice thinks about supplying an additional 100 DAI as collateral in order to better protect her borrow position against becoming liquidable. She would prefer to generate earnings from her 100 DAI, yet simultaneously does not want to risk her position. This is where backd comes in. Alice deposits funds into the DAI pool on backd. In exchange for her DAI she receives a pool-specific LP token, bDAI. She then registers her borrow position by specifying (Note: parameters are user-specific) that her 100 DAI can be used to top up her collateral on Compound in incremental top up amounts of 25 DAI each time her collateralization ratio drops to 120% or lower.

Let’s first assume that Alice’s collateralization ratio does not drop below 120% and therefore her deposited funds on backd are not eligible for top up. A portion of all deposits in the backd DAI pool gets allocated to generate interest for LP token holders according to some investment strategy. For example, the pool could generate interest via depositing funds into the Curve Compound pool, earning trading fees and CRV rewards, which are subsequently sold for DAI. As interest is aggregated over time, the value of 1 bDAI will appreciate over 1 DAI, thereby accruing interest for Alice, as well as all other bDAI holders.

Let us now assume that Alice’s collateralization ratio on Compound falls below the specified 120% threshold. In this case, any Ethereum network participant may act as a backd keeper and report to the backd protocol that Alice is eligible for a 25 DAI top up. If this report is valid, Alice will pay for the collateral top up by redeeming 25 DAI worth of bDAI, while a small top up fee is charged on the top up amount. The incurred fee is in part paid to the backd keeper which reported the top up, while the remainder is distributed to holders of bDAI, i.e. liquidity providers of the bDAI pool.

Components

The design of backd can be broken down into several core components:

Liquidity providers on backd receive pool-specific LP tokens. These are ERC20 tokens and are unique to the backd pool into which funds have been deposited (e.g. bDAI for DAI). The amount of tokens a LP receives is equivalent to his share of the total liquidity for a particular backd pool. As a pool generates interest, its LP token appreciates over the underlying asset.

There are two reasons for holding backd LP tokens: to pay for top ups and to earn interest. When a borrow position is reported for top up, the position’s registrant has to pay by redeeming LP tokens for the top up amount in the collateral asset. Part of the charged top up fee is paid to the backd keeper which reported the top up, while the remainder is retained by the pool and thereby distributed to all holders of the respective pool’s LP token.

The fundamental purpose of the backd protocol is to top up borrow positions. For someone wanting to back a borrow position, he needs to register a position by specifying i) the borrower of the position to back, ii) the address of the protocol on which the borrow positions is, iii) the total amount that may be topped up, iv) the collateral-to-debt ratio at which collateral should be increased, and v) the incremental amount of collateral to be added.

For example, upon depositing DAI, Alice may register a position for herself for top up, by providing the required information (for parameters i-v): Alice, Compound, 100 DAI, 120%, 25 DAI.

Top ups are paid for by redeeming LP tokens of the respective pool for the underlying collateral asset. A top up fee will be charged on the incremental top up amount at every top up. Note that in case the registrant of the top up position has an insufficient amount of LP tokens to pay for the top up, the transaction will not succeed.

Monitoring the collateralization ratios for numerous accounts across various DeFi protocols is a task that is infeasible to be done on-chain. Therefore, backd relies on off-chain keepers to report registered borrow positions which are eligible for top up. These keepers are similar to Auction Keepers on Maker in the sense that these are external agents which are incentivized by profit opportunities to perform certain actions. Anyone is able to take up the role as a backd keeper and report a borrow position eligible for top up to the contract of the associated backd pool. The contract subsequently checks whether the call for top up matches the registered position’s prespecified criteria (e.g. account, total top up amount, incremental amount, threshold, the associated protocol). Should this not be the case, i.e. the collateral position is not eligible for top up, then the transaction will fail and the backd keeper has to pay for the gas cost of the transaction. In case the top up transaction is indeed valid and the top up succeeds, a fee is charged on the top up amount and subsequently split between the keeper and all other depositors of the associated backd pool. Additionally, the keeper of a position that has been topped up is subsequently reimbursed for the gas cost, which is covered by the registrant of the top up position. Thereby the keeper makes a risk-free profit from calling out the endangered position.

At first it may seem unclear as to why a LP would want to hold LP tokens but not back a borrow position, and thereby not make use of a core feature of the backd protocol. The reason for this lies in the incentive mechanism of backd.

Liquidity providers on backd (i.e. depositors into backd pools) earn interest through their LP tokens. The interest generating mechanism is two fold.

  1. For each top up, a small fee is charged on the top up amount and retained by the pool.
  2. Each pool allocates a proportion of its total deposits to some other protocol(s) according to a pool-specific (i.e. asset-specific) yield farming strategy.

Earnings generated by yield farming strategies and top up fees are ultimately claimable by LP token holders when they redeem the underlying asset, as the exchange rate of one LP token to the underlying appreciates over time as the pool grows from strategy returns and accrued fees.

Disclaimer: there will not be a governance token sale, so please do not fall for scams.

The backd protocol is decentralized and we believe in decentralized governance. However, we also believe that a prerequisite for it to work is that the first release of backd is robust and safe. Decentralized governance will incrementally come to backd.

What’s next?

We are working hard to soon be able to release backd v1 on Ethereum mainnet. A more detailed post about backd v1, reporting, initial pools, investment strategies and governance will be released before.

To stay in the loop, follow us on Twitter: https://twitter.com/backdfund

Note: There is no official Telegram group. For any official communication channels check Twitter or https://backd.fund/. Any additional communication channels will be announced via Twitter and backd.fund

backd is a trustless and interest generating protocol designed to prevent collateralized loans from becoming liquidable.

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